Long straddles: The importance of buying time . . . . . . . .10
This comparison of long-term and short-term trade scenarios shows profiting from long straddles is largely a matter of time management. By Jim Graham

Important announcement: This is the final issue of Futures & Options Trader magazine. Starting in May, futures- and options-related content will appear in Active Trader magazine. However, many past Futures & Options Trader articles will be available on the Active Trader Web site later this year.

80 and 0. if price is at the top of this range. In the final trade. red lines). but the market soon reversed and turned down toward the 100-day breakout channel’s lower boundary. soybean oil (BO).5 points.5-point loss. the trade until the standard exit point.20 (the upper and lower 20 percent of the indica.8. The system exited when the HLR indicator dropped below 0.
any trend-following systems generate trade signals when price hits the boundaries of a Defining the strategy breakout channel. The system entered long on March 15. Go long tomorrow with a stop at the highest high This system tries to reduce whipsaw losses with the of the past 100 days.5 points. The upper The system was tested on daily price data from January pane shows the HLR indicator and its threshold values of 1996 to December 2005 on a portfolio of 20 futures con0. The chart contains multiple whipFIGURE 1 — TRADE EXAMPLE saw trades. had the system stayed in this trade. 1. aries. 8 with a loss of 32. avoiding a further loss of 12. price hit a new 100-day high. Exit long tomorrow at the market if the HLR price’s relative location within the high-low range of the indicator drops below 0. of the past 100 days.
BY JOSÉ CRUSET
Note: A version of this article originally appeared in the September 2006 issue of Active Trader magazine. In this case. Another whipsaw trade occurred when the system sold short on May 2 and exited on June 21 after the HLR jumped above 0. but it exits a losing indicator climbs above 0.5. Figure 1 shows an example in corn futures (C). If price is at the bottom of the range. The trade rules for the However. (www.8 and the current position trade if price comes within 20 percent of the channel boundis unprofitable. which shows 2.wealth-lab. it would have exited on May 2 and lost an additional 6 points. 2005 after The HLR indicator helps the system minimize losses. Go short tomorrow with a stop at the lowest low value is 1. going long when price hits To find out whether the HLR indicator can improve pera new n-bar high or going short when it drops formance. corn (C). the system went long on July 14 and exited on Aug. tor’s value is zero.2 and the current position past n bars. However. crude tor's range. Price continued higher and hit a new 100-day high on July 14. its 3. such systems usually trigger many whipsaw system are: trades when the price fails to follow through in the expected direction. the HLR indicator is 0. The HLR system initially enters the 4. in the hope the trend will continue.TRADING STRATEGIES OPTIONS STRATEGY LAB
Channel breakout with HLR
A range-based indicator helps nip false breakouts in the bud. the system would have lost an Source for all figures: Wealth-Lab Inc. the indicais unprofitable.tracts: British pound (BP). HighestLowest-Range (HLR) indicator. it was applied to a basic breakout strategy and to a new n-day low. tested on a broad futures portfolio. and if price is exactly between these boundaries. Exit short tomorrow at the market if the HLR market using standard breakout rules.2 on April 5 — a 29.com) additional 9 points had it held
M
6
March 2010 • FUTURES & OPTIONS TRADER
.

win/loss — The maximum number of consecutive winning and losing trades
Trade statistics
$1. let's say a contract has a point value of $250 and the system goes long at 100 (the basis price) with a stop-loss at 90. hold time — The average holding period for all trades • Avg. gold (GC).89 -43. live cattle (LC).500.50 0. wheat (W). and 30-year T-bonds (US). return — The average percentage for the period • Sharpe ratio — Average return divided by standard deviation of returns (annualized) • Best return — Best return for the period • Worst return — Worst return for the period • Percentage profitable periods — The percentage of periods that were profitable • Max. which results in a singlecontract dollar risk of $2.39% -25.80 -1.95 No. winner — The average profit for winning trades • Avg. profit/loss: Avg. Swiss franc (SF).000.
oil (CL).50 60. consec. drawdown • Max.01 4/16
PERIODIC RETURNS
Avg. consec. Japanese yen (JY). as opposed to cash • Profit factor — Gross profit divided by gross loss • Payoff ratio — Average profit of winning trades divided by average loss of losing trades • Recovery factor — Net profit divided by max.65% 48. Max.81 18.56%
-19. $20 was deducted per round-trip trade per contract for commissions and two ticks of slippage were applied per trade. loss (losers): Avg. hold time (losers.872. DD (%) — Largest percentage decline in equity • Longest flat days — Longest period.29% 9. less commission • Exposure — The area of the equity curve exposed to long or short positions. E-Mini Nasdaq 100 (NQ).000 and you didn’t want to risk more than three percent of the total equity ($30.000. trades: Win/loss: Avg.52%
$4. profit (winners): Avg.22% 1. hold time (days): Avg.17 52. cotton (CT).76% 73.000). For example.69% 1. 5-year T-note (FV). sugar (SB). DD: Longest flat period:
continued on p. E-Mini S&P 500 (ES). A maximum of three percent of account equity was allocated per trade. profit/loss: Avg.64% -21. Eurocurrency (EC). hold time (winners. and the total account equity.93%
0. in days. trades — Number of trades generated by the system • Win/Loss (%) — The percentage of trades that were profitable • Avg. the stop-loss level. the dollar value of a one-point move in the contract.90 = 10). consec. loser — The average loss for losing trades • Avg. The number of contracts is calculated using the basis price (the closing price on the day prior to the entry). silver (SI). If the portfolio’s total equity before entering the position was $1.00
7 — 3
6 4 2
Quarterly 2.46
13.17% 442
146. hold time (losers) — The average holding time for losing trades • Max. consec. trade — The average profit/loss for all trades • Avg.33 0.
STRATEGY SUMMARY
Profitability Net profit:
Net profit: Annualized gain: Exposure: Profit factor: Payoff ratio: Recovery factor: Drawdown Max. you would buy 12 contracts.15
141.FIGURE 2 — EQUITY CURVE The equity curve climbed consistently in the first half of the test period before it became volatile near the end. profitable unprofitable
0. hold time (winners) — The average holding time for winning trades • Avg.21% 19. 8 LEGEND: Net profit — Profit at end of test period.412. in days): Avg. natural gas (NG).24 2.82% 279. consec. lean hogs (LH). profitable — The largest number of consecutive profitable periods • Max. The starting account equity was $1.52 0. win/loss:
297 35.000. the system is between two equity highs • No.31% 24. in days): Max consec.10%
54. coffee (KC). unprofitable — The largest number of consecutive unprofitable periods
FUTURES & OPTIONS TRADER • March 2010
7
. multiply the point value ($250) by the difference between the basis price and the stop-loss (100 .83% Annually 11. To determine the trade’s dollar risk.757. return Monthly Sharpe ratio Best return Worst return Percentage profitable periods Max.86%
LEGEND: Avg.

The rest of the bars represent performance for the system with the HLR exit strategy. The system resembles other trend-following systems because it makes most of its profits from a relatively low number of winning trades (35.
8 March 2010 • FUTURES & OPTIONS TRADER
. Overall.1 to 0. a second test was conducted on the same 100-day channel breakout strategy.3 percent (vs.2 percent for the HLR version) and a maximum drawdown of 50.21 percent.4 and short-exit thresholds from 0.2 percent). ly distributed. Figure 4’s FIGURE 4 — ANNUAL RETURNS yearly returns show profits were unevenThe system’s gains were unevenly distributed across the 10-year test period. The average profit is 1. This standard system had an annualized gain of 7. Figure 3 shows the largest drawdowns (deeper than -40 percent) appeared at the end of the test period. The blue bar in Figure 5 represents the annualized percentage profit of the breakout system without the HLR indicator.
Strategy performance
Figure 2 shows the strategy's equity curve increased consistently in the first five years of the test period.52 percent. so strategy should be quite resistant to higher commissions and slippage. 9.7 percent). 43.9 to 0.5 percent (vs.6. but it became more volatile at the end of the test. For information on the author see p. STANDARD BREAKOUTS indicator effectively cut losses. yearly returns ranged from -21 percent to +49 percent — too volatile for the average trader. and look-back periods. To find out if the HLR component had value. Also.TRADING STRATEGIES
FIGURE 3 — DRAWDOWN CURVE The system suffered the largest drawdowns (up to 43 percent) at the end of the test period. Although the system’s annualized profit was 9. All other parameters and settings remained the same. 5. with the best overall results occurring with exit thresholds of around 0. but not unusual for a trend-following system.3. the HLR FIGURE 5 — HLR EXITS VS. reduced volatility. using long-exit thresholds from 0. The HLR indicator provided an advantage over the traditional breakout method for nearly all parameters. and improved The HLR exit strategy improved performance for almost all parameter combinations performance considerably. Further tests compared performance of using various HLR threshold settings and breakout channel look-back periods. without the HLR exit strategy.

24hrs a day.FX and Futures traders around the globe have counted on TradeTheNews.com to watch their backs through volatile and event driven markets.
SO YOU ALWAYS KNOW WHERE YOU ARE.com
.
For over a decade .
You can depend on our specialized broadcasters and news analysts to recognize opportunities and hazards in real-time.
TradeTheNews.Dealer Chatter: Option Barrier Ahead
Surprise OPEC Production Level Outlook
Sector Check: China Policy Adjustment
Key Technical Levels Ahead of ECB
Unexpected Central Bank Rate Cut
EIA Gas Inventories
Significant FX Chart Formation
Game Changing Stock Event
Negative Same Store Sales
Turbulent times require an experienced co-pilot.

. neither option has any intrinsic value). After explaining how to construct a long straddle. providing a gain by virtue of price movement alone. One way to measure IV in this way is to average the IV levels of both calls and puts and then plot those averages on a graph. Also. volatility tends to return to a more “normal. because a straddle consists of long options. You should also be aware volatility has an important tendency called “reversion to the mean. Also. its value erodes a little bit each day (the process known as “time decay”). we’ll compare two straddles that use options from different expiration months to illustrate how buying more time can create a trade with a higher probability of success. with each data point representing a weekly average. Finally. It’s used when you expect a stock or futures contract to make a big price move but you don’t know whether it will be up or down. 90 percent of the time the IV has been higher than it is currently.TRADING STRATEGIES OPTIONS STRATEGY LAB
Long straddles: The importance of buying time
Buying options has a bad reputation in some trading circles because you’re always fighting time decay.
Putting volatility in your corner
Placing a long straddle on a stock with historically low IV can provide a considerable advantage. Long straddles actually provide two ways to make money: Either the underlying stock can make a big price move. but you want options that are as close as possible. The trick is to determine when options are cheap. it is low compared to past IV readings). A large price move will make one of the legs deep in the money. The first thing to look for when searching for likely straddle candidates is the current IV compared to past IV. and how to measure the effect an IV increase has on an option’s value.
BY JIM GRAHAM
Note: A version of this article originally appeared in the November 2004 issue of Active Trader magazine. as well as low relative to historical. which in early July had IV in the 1-percentile
March 2010 • FUTURES & OPTIONS TRADER
Constructing a long straddle
A long straddle is created by purchasing equal numbers of call and put options on the same underlying instrument and with the same strike price and expiration month. Every asset has quiet periods when its options are cheap and volatile periods when its options are expensive. The best candidates for long straddles are in the 10th percentile of cheapness — that is. you will not always find strike prices that are identical to the current stock price. A straddle’s value is very sensitive to changes in implied volatility (IV).
T
he long straddle is a non-directional option strategy that can yield solid results with low risk. the past three years of volatility history is a good place to start. or IV can increase. This increases the odds IV will revert to a higher level. Options are undervalued when IV is low from a historical perspective (that is. which is the actual volatility of the stock. the next issue we will investigate is how to find straddle candidates with historically low IV levels. Because volatility changes have such a big impact on a straddle’s value. Figure 1 shows an example of a volatility chart for the Biotech HOLDRS (BBH) that showed up as a likely straddle candidate.” average level. Also. Different time periods can be used to calculate this percentile. or statistical volatility (SV). we’ll examine how to take into account the current volatility situation and the effects of time decay when planning a trade. an at-the-money straddle will be cheaper than a straddle whose strike price is not equal to the stock price because it consists of options whose values are composed solely of time value (i.
your favor. Besides price.” After reaching extreme highs or lows.e. another reason to buy at-the-money options is changes in IV will have a bigger impact on them with a few months left to expiration. But knowing how to find options with the best volatility characteristics and tapping into LEAPS can allow you to construct higher-probability long straddles. Of course. Buying undervalued options helps put the odds further in
10
. increasing the straddle’s value. the other variables that affect the value of a long straddle are volatility and time. It makes sense to buy near-the-money options so a sharp price move has a better chance of increasing the position’s value.

For a long straddle to be experience because of a 1-percent IV increase.mum amount of capital to invest.650) expect.allows you to analyze and graphically display the profit or ration. vega is usually shown as the gain or loss a position would option spreads become profitable.
rank. in each case buying as month straddle does not decay much at first. make sure Buy five August 145 calls (BBHHI) at $3. Comparing the possible trades revealed using the 145 strike Theta is always negative for a long straddle because the price had a higher expected return. and as you get closer to expi. month or so before expiration. Look to use farther-out options. Let’s compare how profitable two long straddles in the dle’s long calls and puts constantly declines because of time decay. making BBH options a good candidate for a long straddle. and the other using the January 2007 LEAPS (more than two years to expiration). which is one of Source: OptionVue Systems (www. to make a reasonable profit you need a Biotech HOLDRS might be. The solid line is statistical volatility (SV).40 ($1. IMPLIED VOLATILITY Volatility in the Biotech HOLDRS (BBH) was low overall. As a result.” For ease of use. BBH was trading at 142. Theta is used to measure a position’s sensitivity to the early July. the stock price must be sufficiently dles always have positive vega. But before expiration. having access to a program that The drawback of time Options are a decaying asset.990) Total cost: $4.profitable at expiration. tion would lose in one day due to the effect of time alone. In time decay plus the initial purchase cost. The dashed line is the average IV.90 ($1. stock price.30 ($2. which is why they are pop. but it was also considerably lower than SV (15 percentile rank). one using the August 2004 price move and/or an IV increase that can overcome the options (with 54 days to expiration).800 Choosing the best position Many traders have difficulty understanding exactly how continued on p. and implied volatility was even lower than statistical (historical) volatility. A long strad.350 Term Equity AnticiPation Securities. A six. the rate of decay accelerates. which are options that can expire several years in the future). exactly halfway passing of time. and time have on each leg of the spread. It is usually expressed as the value a posi. Not only was IV currently at its lowest point since options began trading on BBH.loss of a potential option trade is very important. A position’s sensitivity to changes in IV is measured by vega. The shorter-term straddle position is: Because volatility trades take time to develop.the call or put enough intrinsic value to offset the straddle’s dle’s vega is highest when the stock price is identical to the original cost. For that reason. when buying stradThe longest-term LEAPS straddle is: dles to provide plenty of time for IV to revert to its average Buy one January 2007 145 call (OEEAI) at $28. 12
FUTURES & OPTIONS TRADER • March 2010 11
. meaning IV at this time was lower than 99 percent of IV readings over the past six years. the volatility implied by BBH option prices.higher or lower than the options’ strike price to give either ular for exploiting expected increases in IV. indicating the option prices are not even reflecting the actual volatility of the stock.5. Long strad.com) the option “Greeks. The following trade examples used $5.FIGURE 1 — STATISTICAL VS. Buy one January 2007 145 put (OEEMI) at $19. Time decay doesn’t manifest itself immediately.700) you give yourself enough time for IV to make the move you Buy five August 145 puts (BBHTI) at $5.optionvue. and time many contracts as possible to keep the amount invested in decay does not really begin to accelerate until the last the trades as close as possible. you must take into account the simultaneous effect changes in the underlying options’ strike price. which shows the actual volatility of the stock’s daily price changes. The volatility chart has two lines. even LEAPS (LongTotal cost: $4.000 as the maxioptions lose value as time passes.810) level.10 ($2. The value of a strad.between the available strike prices of 140 and 145. implied volatility.

The straddle using the August options has a vega of 215.com) time.92 theta. but there is nothing wrong with For information on the author see p. but closing the position if it has.TRADING STRATEGIES
FIGURE 2 — LONG STRADDLE PROFIT PROFILE The short-term straddle (blue line) has the potential to rack up a sizable profit as long as the underlying stock makes a big move in the next 30 days.7 days just for the position to remain at breakeven. and consider and vega are things you need to consider when trading straddles. notice the longer-term LEAPS straddle would positions using short-term options.7.optionvue. BBH would have to odds further in your favor. the underlying market is in constant motion. it’s a good idea to consider using the pared to a 30-percent loss using the shorter-term options. which means IV must rise 1 percent in only 5. Of course. of doubling your money in a short time In fact. Buying fairly valued options isn’t a bad thing The argument many traders make against buying options is time decay is against you. Despite the drawback term options because you actually have the chance. It can happen.51 in the next 30 days. expecting volatility to be profitable across the range of stock prices as long as IV revert quickly to its mean. Volatility traders often create drop at least $6. just to break even in 30 days — even with future its freedom to move. although small. 5.60. Deciding when to close a long straddle is subjective. In other words. When buymake a 15-percent return (177 percent annualized). which means IV only needs to increase 1 percent every 47. if the stock bounced around but that’s a difficult expectation to meet. you would still cheap options often stay cheap for quite a while. you should use the shorter. make a long straddle profitable.ing long straddles.
12 March 2010 • FUTURES & OPTIONS TRADER
. one leg dle for taking advantage of changes in IV is not going to be will now be worth much more than the other. but ended up right where it started at $142.9 days for the position to stay even.5 when it is placed.buying an option that is fairly valued. but the longterm LEAPS straddle (red line) can profit even if the stock remains nearly stagnant. experience suggests increased 5 percent. The vega/theta ratio is 5. There are no sure things in option trading. You should then determine if standing how to balance likely price moves against theta volatility has returned to more normal levels. time is precisely what gives the underlying stock or period.9 vega and a -2. any price moves by the stock would also affect the positions’ values. The straddle using the January 2007 LEAPS has a 139.9 vega/theta ratio. of time decay. You simply need to evaluate a 5-percent IV increase helping out — the stock would have whether the underlying instrument can move enough to to move down to $137. understanding how a straddle works allows you to put the odds in your favor when using this strategy. If a left when the stock price moves up or down. Figure 2 shows what the two trades would look like 30 days from purchase with a projected IV increase of 5 percent during this Source: OptionVue Systems (www.80 or up to $150. However.2 and a theta of -37.50. In contrast. com. which translates to a 47. longest-dated options available with decent liquidity. It’s clear if you want to swing for the fences and hope a large price move occurs relatively quickly.19 or increase $10. Identifying stocks with inexpensive options puts the to do better than the LEAPS straddle. In fact. The dominant the best one to capitalize on quick moves in the stock price. However. Keep in mind the value of a straddle with more days until That shows just how important buying time can be in deterexpiration will not change as much as one with fewer days mining your probability of placing a successful trade. The best stradmove in the underlying stock has created a gain. Creating positions you’re comfortable with and underleg will then be much more sensitive to changes in the underlying stock price.

the calls will expire worthless and lose their entire cost ($4. If DJX finishes below 96.75 Where: [0]. which tried to find relative lows in the weekly Dow chart. (Close[1]-Low[1])/(High[1]-Low[1]) > . [1].1 percent by options expiration just to overbefore losing ground. High[1]>High[2] 3. and it reverses come the time value of these long ATM calls. last week. Because the pattern is based on a weekly chart and waits 12 weeks for the market to rebound. 11. 2009. Close[1]>Close[2] 5.
continued on p. Source: MetaStock The two-week pattern forms as the Dow bottoms out. the underlying market needs gain ground to overcome this time decay. refer to this week. suggesting it managed to pinpoint some relative lows. The pattern tries to spot market bottoms in the Dow Jones Industrial Average (DJIA).015).03 by expiration. The position of 10 long December 96 calls cost $4. direction in the second week. The formula for entry signals is:
1.
The pattern finds that weeks that start strong and sometimes lose steam are followed by weeks that bounce back and close even stronger. 18. Clearly. (Open[2]-Low[2])/(High[2]-Low[2]) > . the FIGURE 2 — RISK PROFILE – LONG CALLS market opens near the top of its range The underlying must increase by 4. The trade rules simply buy 10 at-the-money (ATM) calls.
System concept: This options lab tests the profitability of a technical pattern first identified in the January issue of Active Trader (“Hitting bottom.OPTIONS TRADING SYSTEM LAB OPTIONS TRADING SYSTEM LAB OPTIONS STRATEGY LAB
FIGURE 1 — BOTTOMING PATTERNS IN THE DOW
Call buying opportunities
Market: Options on the Dow Jones Industrial Average (DJX). 2009 when DJX was at 96. 12). and two weeks ago. Figure 2 shows the potential gains and losses of a long
FUTURES & OPTIONS TRADER • March 2010
Source: OptionVue
call entered on Sept.” p.75 2.06 and held through Dec. [2]. 14
13
. so the strategy involves buying call options to take advantage of an expected rebound. Historical testing shows the Dow rose sharply (and consistently) over the next 12 weeks. the strategy buys calls in the first option expiration month with at least 90 days remaining. In the first week.
Red arrows are the reversal pattern’s entry points. Figure 1 shows this system’s bullish entry points in the Dow since June 2007.015 and would break even only if the market climbed to 100. Low[1]>Low[2] 4.

Note: The total number of trades (18) is a relatively small number to base conclusions on. Test results: Figure 3 shows strategy gained $31. hold time (winners) — The average holding period for winning trades (in days). Buy 10 ATM calls in first month with at least 90 days remaining before expiration. profit (winners) — The average profit for winning trades. profit (winners): Avg. 18. hold time (winners): Avg.510. Statistically. win/loss — The maximum number of consecutive winning and losing trades.170. an annualized return of 12 percent. so the system has a definite trading edge. Avg.33 $11. trade — The average profit for all trades.
Net gain — Gain at end of test period. Exit at expiration by letting the calls expire worthless or exercise into cash. but a losing streak can quickly deplete your capital. otherwise.546.71 129 134 5/4
Option System Analysis strategies are tested using OptionVue’s BackTrader module (unless otherwise noted). Execution: Option trades were executed at the average of the bid Source: OptionVue and ask prices at the daily close. if available. loss (losers): Avg.com. Avg. 2009. When signal triggers on Friday’s close: 2. No.82). and the drawdown grew to $24. hold time (losers) — The average holding period for losing trades (in days).546. theoretical prices were used.
14
March 2010 • FUTURES & OPTIONS TRADER
. Largest winning trade — Biggest individual profit generated by the system. Avg.71) was less than its average winning trade ($6.200 104% 12% 18 11/7 61% $1. Commissions were $15 per trade. the system traded 18 times in eight and a half years. ATM long calls have a probability of winning about 33 percent of the time. It would require a great deal of courage to actually LEGEND: trade such a volatile system. Avg. trade: Largest winning trade: Largest losing trade: Avg. The first four trades in 2001 all lost money.OPTIONS TRADING SYSTEM LAB
FIGURE 3 — SYSTEM PERFORMANCE
Trade rules:
Following a two-week bottoming pattern in the Dow earned 104 percent since April 2001. Annualized return — Gain or loss on a annualized percentage basis.830.
1.200 (104 percent) since April 2001. please send the trading and money-management rules to Advisor@OptionVue. of trades — Number of trades generated by the system.82 -$5. The strategy’s average losing trade (-$5. Max consec.00 $6. Overall. of trades: Winning/losing trades: Win/loss: Avg. Win/loss — The percentage of trades that were profitable.000 $31. Winning/losing trades — Number of winners and losers generated by the system. Test data: The system was tested on cash-settled Dow Jones index (DJX) options. If you have a trading idea or strategy that you’d like to see tested. Avg. Percentage return — Gain or loss on a percentage basis. win/loss: $30. but the strategy had deep and prolonged drawdowns from 2001 to 2006. hold time (losers): Max consec. loss (losers) — The average loss for losing trades. 2001 to Dec. — Steve Lentz and Jim Graham of OptionVue
STRATEGY SUMMARY Initial capital: Net gain: Percentage return: Annualized return: No.915. Largest losing trade — Biggest individual loss generated by the system.
Starting capital: $30.00 -$8. 61 percent of which were profitable.830.000.733. Test period: April 12.

Theta: The rate at which an option loses value each day (the rate of time decay). Gamma: The change in delta relative to a change in the underlying market.KEY CONCEPTS
The option “Greeks”
American style: An option that can be exercised at any time until expiration.
of a short call and a higher-strike. which has more value. At the money (ATM): An option whose strike price is identical (or very close) to the current underlying stock (or futures) price. which costs more. You buy the lower-strike call. Note: These labels are not set in stone. Assign(ment): When an option seller (or “writer”) is obligated to assume a long position (if he or she sold a put) or short position (if he or she sold a call) in the underlying stock or futures contract because an option buyer exercised the same option. Unlike delta. You buy the higher-strike put.5 would move a half-point for every 1-point move in the underlying stock. so the potential profits are unlimited and losses are capped. higherstrike call. Bear put spread: A bear debit spread that contains puts with the same expiration date but different strike prices. Bollinger Bands: Bollinger Bands are a type of trading Bull call spread: A bull debit spread that contains calls with the same expiration date but different strike prices. and sell the less-expensive. Bull put spread (put credit spread): A bull credit spread that contains puts with the same expiration date. Bear call spread: A vertical credit spread that consists Delta: The ratio of the movement in the option price for every point move in the underlying. but different strike prices. and its maximum loss is limited to the point difference between the strikes minus that premium. Backspreads contain more long options than short ones. gamma is highest for ATM options and lowest for deep ITM and OTM options.00 would move 1 point for every 1-point move in the underlying stock. ratio spreads have more short options than long ones and have the opposite risk profile. Backspreads and ratio spreads are leveraged positions that involve buying and selling options in different proportions. usually in 1:2 or 2:3 ratios. and increases as the option gets closer to its expiration date. Theta is relatively larger for OTM than ITM options. lower-strike put. further OTM long call in the same expiration month. an option with a delta of 1. and sell the cheaper. lowerstrike put. Vega: How much an option’s price changes per a onepercent change in volatility. Butterfly: A non-directional trade consisting of options with three different
20
March 2010 • FUTURES & OPTIONS TRADER
. You sell an OTM put and buy a less-expensive. An option with a delta of 0. Some traders describe either position as option trades with long and short legs in different proportions. The spread’s largest potential gain is the premium collected. By contrast. Rho: The change in option price relative to the change in the interest rate. which is highest for deep ITM options.

Clearing members. Commercial hedgers are typically those who actually deal in the cash market (e. the general public. However. The final COT category is called the nonreportable position category — otherwise known as small traders — i. Calendar spread: A position with one short-term short option and one long same-strike option with more time until expiration. Debit spread: An options spread that costs money to enter. For each futures contract. a December 50 call and a January 60 call. Diagonal spread: A position consisting of options with different expiration dates and different strike prices — e. calendars.strike prices at equidistant intervals: Long one each of the highest and lowest strike price options and short two of the middle strike price options. This group consists mostly of institutional and quasi-institutional money managers who do not deal in the underlying cash markets. Call option: An option that gives the owner the right. in which case you keep the premium.g. OTM options can be used to profit from both a directional move and time decay. the delivery period for March T-notes will be a specific period in March. An example would be purchasing a stock for $50 and selling a call option with a strike price of $55. it is market-neutral and tries to profit from time decay.e.g. but not the obligation.. European style: An option that can only be exercised at expiration. the Commitments of Traders (COT) report breaks down the open interest in major futures markets. because the long side is more expensive that the short side. These dates vary from market to market and are determined by the exchange. A credit spread using calls is bearish. Delivery period (delivery dates): The specific time period during which a delivery can occur for a futures contract. while a credit spread using puts is bullish. not before. If the spread uses ATM options. Non-commercial large traders include large speculators (“large specs”) such as commodity trading advisors (CTAs) and hedge funds. to buy a stock (or futures contract) at a fixed price.. Credit spread: A position that collects more premium from short options than you pay for long options. and foreign brokers are required to report daily the futures and options positions of their customers that are above specific reporting levels set by the CFTC.. report data is divided into three “reporting” categories: commercial. who either produce or consume the underlying commodity) and can have access to supply and demand information other market players do not. non-commercial. or diagonals. They typically fall during the month designated by a specific contract — e. The “commercials” are often referred to as the large hedgers. grain merchants and oil companies. The first two groups are those who hold positions above specific reporting levels. Covered call: Shorting an out-of-themoney call option against a long position in the underlying market. The Commitments of Traders report: Published weekly by the Commodity Futures Trading Commission (CFTC). but speculate in futures on a large-scale basis for their clients.g. futures commission merchants. 22
21
. The goal is for the market to move sideways or slightly higher and for the call
FUTURES & OPTIONS TRADER • March 2010
option to expire worthless. These spreads can be verticals.
continued on p. and non-reportable positions.

or a put option with a strike price below the underlying instrument’s price. If you sell a put. If the market drops below the short put’s strike price. crude oil.. the holder may exercise it. requiring you to buy stock at the strike price (i. although no certificates change hands. If you sell a call. but not the obligation. Although 98 percent of all futures contracts are not delivered. A call option with a strike price of 22 has 2 points of intrinsic
value if the underlying market is trading at 24.KEY CONCEPTS
Exercise: To exchange an option for the underlying instrument. Given its risk. with the underlying instrument trading at 50. and newer traders aren’t usually allowed by their brokers to trade such strategies. for example. Naked (uncovered) puts: Selling put options to collect premium that contains risk. to sell a stock (or futures contract) at a fixed price. Open interest: The number of options that have not been exercised in a specific contract that has not yet expired. Near the money: An option whose strike price is close to the underlying market’s price. Parity: An option trading at its intrinsic value. a 45strike call option with a premium of 8. you are obligated to sell the underlying instrument at the call’s strike price. Out of the money (OTM): A call option with a strike price above the price of the underlying instrument. which might be below the market’s value. Expiration: The last day on which an option can be exercised and exchanged for the underlying instrument (usually the last trading day or one day after). above the market). In the money (ITM): A call option with a strike price below the price of the underlying instrument.e. T-note delivery is taken by a bookentry transfer of ownership. which may be well above the market. there are market participants who do take delivery of physically settled contracts such as wheat. and Tnotes. Naked option: A position that involves selling an unprotected call or put that has a large or unlimited amount of risk.50 of extrinsic value. Premium: The price of an option. Extrinsic value: The difference between an option's intrinsic value and it's current price (premium). for example. For example. or a put option with a strike price above the underlying instrument’s price. triggering a loss. Put option: An option that gives the owner the right. Front month (or “nearest month”): The contract month closest to expiration. selling naked options is only for advanced options traders. you are obligated to buy the underlying instrument at the put’s strike price.
22
March 2010 • FUTURES & OPTIONS TRADER
. also causing a loss.50 has 3. Intrinsic value: The difference between the strike price of an in-the-money option and the underlying asset price. Commodities generally are delivered to a designated warehouse. Physical delivery: The process of exchanging a physical commodity (and making and taking payment) as a result of the execution of a futures contract.

5
Strangle: A non-directional option spread that consists of an out-of-themoney call and out-of-the-money put with the same expiration. the higher the option premium. For example. LJM Partners (Aggr. 2009 YTD $ under declining volatility.6 2. If the stock drops well below $40.
2. ACE Investment Strat (ASIPC INST) 9.com) Based on estimates of the composite of all accounts or the fully funded subset method. Premium Writing) 3.55% 3.74% 3.g.barclayhedge. with the underlying instrument trading at 25. a standard long straddle would consist of buying a 25 call and a 25 put. Long Top 10 option strategy traders ranked by January 2010 return.6 30.) an increase in volatility. For example. short strangles are intended to capitalize on declining volatility. if a stock trades at $50. higher-strike puts and long.1 1.61% 3. Volatility: The level of price movement in a market.38%
7.
1. the short $45 put might move into the money. a September 40 call option and a September 50 call option). future. Historical (“statistical”) volatility measures the price fluctuations (usually calculated as the standard deviation of closing prices) over a certain time period — e. which means each day’s price is equally weighted in the calculation.50% 1. 31. Long strangles are designed to profit from an increase in volatility.4 10.Put ratio backspread: A bearish ratio spread that contains more long puts than short ones. The straddle is a related strategy. Kawaller Fund
9. Strike (“exercise”) price: The price at which an underlying instrument is exchanged upon exercise of an option. a long strangle could consist of buying a 27.5 call and a 22. time value decreases at an accelerated rate. The short strikes are closer to the money and the long strikes are further from the money. or other market over a certain time period. The strangle is a Rank Trading advisor return return mgmt. Implied volatility is the current market estimate of future volatility as reflected in the level of option premiums.8 1.8 37. The higher the implied volatility.21% 6. with the underlyMANAGED MONEY ing instrument trading at 25. Oak Investment Group (Ag Options) 3. Does not reflect the performance of any single account. Time spread: Any type of spread that contains short near-term options and long options that expire later. potential gains are unlimited until it reaches zero.00% 6.19% 6.50%
Source: Barclay Hedge (www. short straddles are intended to capitalize on Nov.” Vertical spread: A position consisting of options with the same expiration date but different strike prices (e.. A five-day SMA is the sum of the five most recent closing prices divided by five. straddles are designed to profit from (Managing at least $1 million as of Jan. A bear put spread is structured differently: Its long puts have higher strikes than the short puts. NEOS Advisors (Special Opportunities) 3. but the long lower-strike puts will hedge some (or all) of those losses.84% 9.84% 9. Financial Comm Inv (Option Selling) 5. a phenomenon known as “time decay. As expiration approaches. CKP Finance Associates (Masters) 4.6 13.15%
5.74% 8.00% 6. If the stock drops.38% 3.15% 5. Simple moving average: A simple moving average (SMA) is the average price of a stock.5 put.
Straddle: A non-directional option spread that typically consists of an at-the-money call and at-the-money put with the same expiration. Kingsview Mgmt (Retail) 3. you could sell one $45 put and buy two $40 puts in the same expiration month. Both options can share a strike price (calendar spread) or have different strikes (diagonal spread). Time value (premium): The amount of an option’s value that is a function of the time remaining until expiration.
FUTURES & OPTIONS TRADER • March 2010
23
. ACE Investment Strategists (DPC) 4. related strategy.55% 10. Put spreads: Vertical spreads with puts sharing the same expiration date but different strike prices.7 5.61%
9.g. lower-strike puts.19% 6.21% 4.. For example. A bull put spread contains short.6 44. the past 20 days.
Time decay: The tendency of time value to decrease at an accelerated rate as an option approaches expiration. 2009. Carter Road 3. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE.

but also displays a visualization of probabilities for any price move. a new Equity Research Center provides corporate earnings announcements.org.com). and a comprehensive view of stock and option “most actives” and “gainers/losers. another patent-pending tool for option traders available to all tradeMONSTER customers free of charge.moneyshow. Sydney to Auckland For more information: Go to www.com includes expanded educational content provided by the CBOE Options Institute. a target price range they believe the security will be in for a given time period. guided option education program that helps students of all levels improve their options investment skills. the Education Center provides an interactive “Education Snapshot” tool that lets visitors automatically monitor their educational progress. London For more information: Go to www. analyst revisions. New features Education Center include Options Institute Plus. Site enhancements include simplified navigation that guides user groups through the most relevant site content. For more information: Go to www. and dividends and guidance information and allows investors to input and monitor personal portfolio information. This is accomplished by clicking on a chart that not only shows the price history. and customized features for different types of options investors.com/caot/?scode=013721
March 2010 • FUTURES & OPTIONS TRADER
.moneyshow. With one click. an online game that challenges investors’ options knowledge and helps them sharpen their trading skills.com.com. order your priorities with safety as your top preference and strategySEEK will give more weight to strategies with the smallest potential downside. Los Angeles For more information: Go to www. a comprehensive. Web casts.com
24
Event: The World MoneyShow Vancouver 2010 Date: April 6-8 Location: Hyatt Regency Vancouver For more information: Go to www. The tradeMONSTER platform then creates thousands of strategy combinations in real-time. It allows traders to identify strategies that best fit their general or specific forecasts about the underlying security.futuresindustry. The risk priorities in strategySEEK also include probability and return and can be toggled on or off with a single click.CBOE.” Additionally. The site also now includes an improved quotes section that incorporates advanced charts. The Chicago Board Options Exchange (CBOE) has re-launched its Web site (www. performing over a million calculations to come up with the top strategies. Chiswell Street. a tradeMONSTER customer can enter their market forecast as either a target price they believe the security will be at a given time period. Fla. the customers can then analyze it in tradeLAB.trademonster.idw. an interactive education center featuring new programs. E-mail press releases to editorial@futuresandoptionstrader. and a customizable “myCBOE” feature.moneyshow. visit www. modify it. three virtual trading tools for strategy testing. market news.asp Event: The 11th Free Technical Analysis Expo Date: March 26-27 Location: Paris. For more information.
Note: The New Products and Services section is a forum for industry businesses to announce new products and upgrades.uk Event: Los Angeles Traders Expo Date: June 9-12 Location: Pasadena Convention Center. The new site features faster navigation. The new CBOE.asp Event: FIA/FOA International Derivatives Expo Date: June 8-9 Location: The Brewery.org Event: The 17th Forbes Cruise for Investors Date: March 18-30 Location: Crystal Symphony.com/events/World_MoneyShows. France For more information: Go to www. or send it to the market.salonat. If you’re an aggressive investor who is most focused on finding strategies that represent the maximum profit.
EVENTS
Event: 35th Annual International Futures Industry Conference Date: March 10-13 Location: Boca Raton Resort & Club. StrategySEEK also allows online investors to adjust their strategies and will find the appropriate strategies for investors regardless of their risk appetite and investment objectives. The strategySEEK tool allows investors to identify the best possible strategies for their option trades based on their market forecasts and personal risk preferences. and OptionQuest. or a range the security will not be in for a given time period. Publication is not guaranteed. If your main concern is minimizing potential losses.NEW PRODUCTS AND SERVICES
Online broker tradeMONSTER has released strategySEEK.com/events/Investment_Cruises. you can tell strategySEEK to give more weight to strategies that offer the biggest potential upside. With this new technology. Listings are adapted from press releases and are not endorsements or recommendations from the Active Trader Magazine Group. In addition. richer content.

20 % 0. A push above resistance at the $1114.m. individual trades are a function of immediate market behavior. the initial (pre-trade) reward-risk ratios are conjectural by nature.40 Date 2/22/10 Point 2.m. a result of not liking the force of the pull. Having been burned recently on some longer-term posiInitial stop: 1112. level was likely even if the market turned back down we decided to make another attempt as progressively high.20 1112. LOL — largest open loss (maximum potential loss during life of trade).
Note: Initial targets for trades are typically based on things such as the historical performance of a price pattern or trading system signal. market’s swing high around 10:40 a. but it was executrebound. we looked for an opportunity to take a bite out of the expected Outcome: Not exactly a monster trade. nearly reaching $1116 in the next fivelevel supported the bias. LOP — largest open profit (maximum available profit during lifetime of trade).
26 March 2010 • FUTURES & OPTIONS TRADER
. Feb.50 sharply higher.40 IRR 1. 22.10. Reason for trade/setup: This was a pure day-trade scalping opportunity. Profit/loss: +2.m. and we entered a limit order to minute bar. er lows on the five-minute chart pointed to a build-up of After dipping slightly after entry. but rather than abandon the idea. it was satisfying (and therapeutic) to operate successfully.20. tions.20.
RESULT
Exit: 1116.
However.50 around 11:30 a. An early morning sell-off took April gold from Source: TradeStation around $1126 to $1100 by 11 a. initial price targets are flexible and are most often used as points at which a portion of the trade is liquidated to reduce the position’s open risk.
TRADE SUMMARY
P/L Date Contract Entry price Initial stop Initial target 1114. Entry: Long April gold (GCJ10) at 1114. An initial buy at $1112.10 1116.(which turned out to be what happened). the market turned bullish momentum. We raised the stop to around breakeven at that enter on a small pullback. As a result.50 got shaken out of the ed according to plan and did what it was designed to do.60 Length 12 minutes
2/22/10 GCJ10
Legend: IRR — initial reward/risk ratio (initial target amount/initial stop amount). and the market hit the exit order during the next bar.80 LOL -0.FUTURES TRADE JOURNAL
Gold scalp pans out.40.
TRADE
Date: Monday. A challenge to this It was a premature exit.40. point.10. market at $1113.05 Exit 1116. Initial target: 1116. 2010. even on a small scale.20% LOP 2. After the market stabilized for a few minutes.The exit level was chosen because it was a little below the back from $1114.

OPTIONS TRADE JOURNAL
FIGURE 1 — SHORT SIGNAL — SPY After a string of higher daily highs.19
110. which triggered on Feb.m. we plan to buy a March 115-strike put outright. a short signal in SPY was triggered on Feb. 22 Feb. Given our moderately bearish outlook. 21-26. SPY hit 111.60 5. based on four consecutive higher Source: eSignal daily highs. 19. we still plan to bet against the market if SPY reaches that day’s high of 111. SPY has weakened after similar patdrops during the week of Feb.57). The position is deep ITM with a -82 -1. However.” January 2010).19
FUTURES & OPTIONS TRADER • March 2010
27
. we bought the put for $4. terns. so it should resemble an outright short trade.) 48% 51% Probability of profit: Note: This was a paper trade. the position is far enough in-the-money (ITM) Source: OptionVue to profit quickly if SPY declines sharply. part 10. forming only FIGURE 2 — RISK PROFILE — LONG PUT once (in July 2009) since the broad market bottomed Like a short underlying trade.55 Delta: Figure 2 shows the March 115-strike put’s potential gains 4.26 -88. 25.
TRADE Date: Monday. 28
110. Although we missed the short signal on Feb. triggering an up move that gained steam in the holiday-shortened week of Feb. 22 Market: Options on the S&P 500 tracking stock (SPY) Entry: Buy one March 115-strike put for $4.28 Vega: areas represent expected targets from historical testing.17 Theta: delta.2 percent from its Jan.81 when Date Feb. -82. SPY stalled on Feb. 23 SPY traded at 111. we should enter a bear put or call spread to reduce risk.
This bearish trade follows a well-timed short signal from a stock index swing system. 19.81. We first discussed this short-selling opportunity as part of Active Trader’s ongoing System Design series (see “System Design. Running in circles.05 at 3:45 p. this long March 115 put will profit if SPY in March 2009. 19 high. Reasons for trade/setup: After falling 9. In the final hour of trading.50. The rebound led to a short signal.44 5. the trade’s time frame is only three days — too short for a hedged position to pan out. 15-19. SPY reversed direction on Feb.50 and TRADE STATISTICS seemed poised to reach our entry stop price (111. Instead. But after the market pushed lower. 19 (Figure 1).5 percent within four days from 1993 to 2009.87 Gamma: and losses by Feb. ET. The short signal has been fairly rare. 22 as the market struggled to break above a resistance level around 111. Feb.
Breakeven point:
continued on p.68 -2. (Shaded 8. The market seemed poised to give back some ground the next day.57. falling a median 1. 5.

99 (21 percent). Initial target: Exit after three days or if SPY drops to 110 (based on historical testing).m.OPTIONS TRADE JOURNAL
TRADE SUMMARY Entry date: Monday. Feb.68 2 days $99 (21%) $99 -$21
Initial stop: Exit if SPY climbs to 113 (based on historical testing).
THIS MONTH’S ADVERTISERS THIS MONTH’S ADVERTISERS
Click on these boxes to link directly to these advertisers’ Web sites
28
March 2010 • FUTURES & OPTIONS TRADER
. and we sold the March 115 put for $5. The S&P fell roughly 1 percent to 110 within 10 minutes. 22 S&P 500 tracking stock (SPY) 1 long March 115 put $481 Exit if SPY rises to 113 Exit after 3 days or if SPY falls to 110 $1.
Underlying security: Position: Initial capital required: Initial stop: Initial target: Trade length: Initial daily time decay:
RESULT Outcome: SPY traded sideways the next morning before February’s disappointing consumer confidence reading shook the market at 10 a. LOL — largest open loss (maximum potential loss during life of trade).
P/L: LOP: LOL:
LOP — largest open profit (maximum available profit during life of trade).80 — a gain of $0.